JAN van Riebeeck landed in the Cape in 1652, an event that would forever alter the history of what later became known as SA . The first governor of the Dutch settlement, who spent only 10 years of his life in Africa, probably had little idea how much impact his stay would have. It is likely he had even less of an inkling that, centuries later, the so-called Dutch disease would still be stifling balanced growth in SA and still be laying the ground for market volatility.
By Dutch disease, we refer to the situation — familiar to economists — in which the price of one (or several) commodities exported by a country rises in relative terms, leading to a real appreciation of that country’s currency, which in turn undermines the external competitiveness of other sectors of that country’s economy.
At its worst, Dutch disease can force companies to close, can increase the dependency of the country on exports of unprocessed goods, and can increase the volatility of both its real and financial aggregates.
In a paper published in 2007, Prof Jeffrey Frankel of the Harvard Kennedy School identified a phase of Dutch disease in SA in 2003- 06, with the rand exchange rate primarily determined by real prices of SA’s mineral exports over that period.
Indeed, the real effective exchange rate of the rand appreciated 32% from 2002 to 2006, while real export growth averaged only 4% — versus an average growth rate of 9,8% for global trade — and the current account swung from a surplus of 0,8% of gross domestic product (GDP) in 2002 to a deficit of 6,3% in 2006, despite a 10% appreciation in SA’s terms of trade.
The following years saw the rand depreciate sharply.
But it is now worth asking whether Dutch disease is returning to SA, in view of the currency’s immense gains in trade-weighted terms since its December 2008 trough.
To some extent, the rand’s recovery can be viewed as a “normal” correction from an unusually wide depreciation, accompanying the normalisation in global investor appetite for “risky” assets such as emerging market equities, currencies and commodities.
But it is the size of this rebound that appears challenging from a macroeconomic perspective.
Let’s look at some numbers: in July, according to Bank for International Settlements data, the rand’s real effective exchange rate was 12,1% higher than its average for the first half of last year — that is, before the worst of the global financial crisis. Next among large emerging countries is China (5,7% higher), while the currencies of Brazil, Turkey, Chile, Mexico, Poland and South Korea all are down on the same basis — in the case of the latter three, by more than 10%.
And it is difficult to argue that this relative outperformance of the rand reflects better fundamentals: the contraction in SA’s economy in the first two quarters of this year puts it in the lower tier of emerging markets.
As for consumer price inflation, the July reading of 6,5% in SA places it in the highest quartile of world inflation rates — with some of those countries experiencing higher inflation, such as Iran, Venezuela or Ukraine, not generally known as models of macroeconomic or policy stability.
Admittedly, SA’s current account deficit narrowed considerably in the second quarter, to 3,2% of GDP, a ratio that had not been seen since the beginning of 2004. But most of the other emerging economies with traditionally “high” external deficits also experienced a reduction in their shortfalls, sometimes of a greater magnitude than in SA. So what can be used to explain a recovery in the rand in absolute terms is not valid when doing relative comparisons.
Many will argue that the stronger rand is a boon, not a bane, and that policy makers should welcome it rather than try to combat it. One main argument in favour of strong currencies is that seeking “competitive devaluations” is the easy way out for companies that fail to engage on the necessary productivity and diversification efforts — in essence, devaluations delay structural reforms. Another argument is that they reduce the risk premium on local financial assets and, in turn, the cost of financing the economy. In the current case, the stronger rand has two other benefits for SA: it helps lower the rate of inflation, and reduces the cost of imported components of the infrastructure build programme — easing pressure on public finances.
These arguments are valid, and it is not my intention to advocate a “weak rand”. But my concern is that the superimposition of a strong currency on what is by many standards a fragile, if not weak, economy may be a recipe for disaster.
For what happens next? The current mix of a lower current account deficit, steady commodity prices and solid performance of “risky” assets worldwide can result in the rand remaining stable for longer — maybe six to 12 months, especially if the 2010 Soccer World Cup provides, as one can expect, a temporary boost to tourism-related inflows. But the relative rigidity of inflation means that even a stable exchange rate implies an appreciation in real terms, and a resulting further loss of competitiveness.
This is particularly true in the sector that has already suffered most in the past decade — manufacturing. Reserve Bank data show that by the end of the first quarter, unit labour costs in that sector were already rising by a staggering 21% year on year. The consequence is that even as global demand recovers, South African exports will soon “bump” against that competitiveness constraint, and that the pattern of 2003-06 — real export growth underperforming against global trends — may well be repeated.
Meanwhile, the recent plunge in imports — which was the one reason behind the marked narrowing in the external deficit, but which mainly reflected the collapse of inventories — is bound to reverse once the demand cycle turns. Current account shortfalls of 5%- 6% of GDP could again become the norm, rather than the exception. The day foreign investors reduce their purchase of local assets — even without them selling these assets — would then see another sharp rand correction, similar to those of 2006 or last year.
And since price- and wage-setting are relatively rigid in SA, a sharp depreciation of the rand looks bound to trigger a new inflation spike, to raise the risk premium on local financial assets and to force the Reserve Bank into rates that many entrepreneurs and households will find difficult to bear.
At the end of the day, the cost of financing of SA’s economy will have proven to be higher, not lower, for the sole reason that unsustainable currency moves mean volatility — a volatility that has to be reflected in the risk premium on South African financial assets.
Limiting rand volatility is easier said than done. But the Reserve Bank retains the option of sterilised reserve accumulation in periods of rand strength, a tool it used in 2006-07 but has not employed, so far, in the latest phase of appreciation.
Smoothing the currency’s path may at least go some way towards limiting volatility. Sometimes one must limit one’s ascent to ensure the eventual downfall is less painful.
n Mercier is Citigroup economist in SA.
Superimposition of a strong currency on what is by many standards a fragile economy may be a recipe for disaster